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New Tax Rules for Employee Stock Options

27/10/2010


The 2010 Federal Budget proposed changes that will have a significant impact on public companies that use stock options as a means of compensation. These changes relate to how stock options are taxed in the hands of employees, directors and officers, and they come into effect in just a few months. The tax treatment of stock options issued to third parties not employed by the company has not changed.

Stock options are taxed according to specific rules. A stock option benefit is calculated when the employee exercises their options based on the difference between the fair value of the shares and the exercise price: this benefit is treated as employment income for tax purposes. When the employee eventually disposes of the shares, additional tax is payable on any resulting capital gains.

Employees of public companies have been able to file an election with Canada Revenue Agency (CRA) to defer the taxation of most stock option benefits until the year in which they dispose of the shares; this allows them to pay the tax liability from the proceeds of the sale. Employees who have filed this election are not subject to withholding taxes on the stock option benefit. However, because of recent stock market declines, many employees have found themselves in a position where the stock price on the date of disposal does not provide them with enough cash to fund the taxes owing.

Due to the financial hardship this may create, the ‘deferral election’ has been repealed in the 2010 Federal Budget. In addition, for stock options exercised after 2010, employers will be required to withhold and remit source deductions on stock option benefits at the time the options are exercised. This ensures the funds are paid up front and shifts the responsibility from the employee to the employer.

There are limited exceptions to these requirements; however, at this point, companies will need to review their stock option plans and make any necessary changes to ensure they are in compliance with the new legislation, and that they can meet their withholding obligations. In many cases, changes will be required. For example, since employers may be forced to make cash remittances to the CRA regardless of having received sufficient funds from the employee, the plan may need to be amended to give the employer the legal right to sell a portion of the newly acquired shares in order to fund the source deductions.

Alternatively, a legal right may be given to the employer to request additional funds from the employee as a condition of exercise. As we move closer to 2011, such amendments should be addressed as soon as possible - existing option holders may be required to approve the changes. In any case, legal counsel should be consulted, and board approval should be obtained prior to any changes being made.

For further information or to find out how we can help, contact Annie Storey, CA, MNP Public Companies, or your local MNP advisor.